Long-Term Incentives in the Era of Strategic Agility

January 17, 2020

Conventional Three-Year Performance Share Programs Have Limits

By Barry Sullivan and Seymour Burchman

If you were to choose a top-five management practice born in Silicon Valley that promises to grow to maturity in corporations everywhere, you would have to include business agility.

Agility in digital product development.

Agility across business units.

Agility in corporate strategy.

The fast pace of agile companies raises a question for corporate compensation committees. If your company’s success in the future demands short-term strategically agile changes, how can you continue to structure long-term incentives based on long-term strategy? Have conventional, performance-based, long-term equity plans that pay out against financial and three-year strategic achievements gone out of date?

For more than a decade, conventional wisdom of three kinds has guided the design of executive pay: That executives work solely in the interests of shareholders. That executive success can be gauged by the execution of strategy. That the most appropriate time period for measuring successful strategy execution is three years. The question that the advent of strategic agility raises is whether we might be approaching a tipping point.

 

Are Changes in Store for Long-Term Incentives?

Strategic Agility as a New Core Competency Points to Seven Possibilities

  1. Mission: An enduring mission, rather than a one- to three-year strategy, will increasingly drive long-term incentive programs. That means executives and boards will remake company mission statements to offer more strategic guidance.
  2. Key constituency: Missions will commit the company to serve one or two key stakeholders, with shareholders an implicit priority.
  3. Goals: Executives will be charged with meeting both financial and nonfinancial long-term goals based on outcomes drawn from the mission.
  4. Time horizons: Mission-driven goals will remain stable over multiple cycles, replacing strategy-driven goals that vary every year or so.
  5. Steady gains and out-performance: Long-term incentive goals will be formulated based on continuous improvement in outcomes (not outputs) and besting the competition, rather than on milestones in strategic plans.
  6. Payout cycles: Incentive plans will pay out based on end-to-end long-term performance periods, rather than on overlapping three-year cycles with annual resets.
  7. Stock ownership: Executives will be required to hold substantial stock over even longer terms, possibly beyond retirement.

The evidence is that, in agile companies, the answer is yes. If conventional plans are left unchanged, they may actually hamper strategic agility and long-term success. That’s because assumptions that stretch out over three years often change in a snap. New competitors arise because of globalization, new entrants tap global capital markets for seed money, old industry boundaries weaken and allow industries to converge — witness Amazon, Airbnb, and Netflix.

Sticking to one strategy can hurt a company’s nimbleness. Many agile tech companies change their strategies as often as every quarter. The companies do so because executives are taking their cues from changing assumptions recognized by on-the-ground agile development teams, the people close to the customer and immersed in real-time technological change. The agile action of teams throughout the organization obliges executives to rethink strategy at the top. (Note: although we primarily talk about tech companies in this article, the fast pace of technological and other changes in virtually all industries will require even more staid businesses to become more agile.)

But here’s the catch. Conventional long-term incentive goals that stretch out over three years don’t align with the agile time span of three months. Incentives that persist that long can motivate executives to drive obsolete strategies. Although the level of risk to the company is a subject of debate, there’s no denying the mismatch.

Is there a better driver for long-term incentives than three-year strategies? One driver already on hand is the mission. What about tying long-term compensation to achieving the mission, an enduring purpose, instead of tying it to achieving long-term strategy, a waypoint on the trail to achieving that purpose? That eliminates the disincentive in pay to pursue fast-paced strategic shifts.

That’s not to say that you no longer ask people to execute strategy — or stop giving them rewards for doing so. But you could tie strategy execution to annual incentive pay and mission execution to long-term incentive pay, creating a new and natural balance in pay design to support both strategic execution and strategic agility.

The New Mission

One challenge is obvious: Corporate mission statements today, usually linked at the hip with vision statements, are all over the map. Some are so general as to offer inadequate guidance for focusing the efforts of executives, let alone agile teams and broad workforces. The missions lack specifics of any kind. As a result, mission statements, if they become the basis for rewarding executives for multi-year long-term performance, need revamping.

If you’re a director concerned with incentive compensation, you’ll want to see mission statements rewritten to fulfill two ends: first, to guide the organization’s actions in an agile era, and second, to provide clear direction to formulate long-term incentive goals. That means mission statements should answer three questions:

  • Who or what are you benefiting—which stakeholder needs do you aim to satisfy?
  • What outcomes do you seek for stakeholders?
  • How can you continuously improve these outcomes—and outperform competitors?

Many mission statements, even when paired with vision statements, don’t specify all three, which disqualifies them from facilitating mission-driven strategic agility. A strong tie is possible only when you specify which stakeholders you’re trying to benefit; what outcomes you’re trying to deliver for those stakeholders (not outputs from the company); and what you need to do to improve outcomes over time and better than competitors.

Among the key long-term goals in incentive plans will be shareholder value. You have to show you’re benefiting owners and investors, whose claim on company success is implicit. But the goals should also charge executives with making life or work better for customers and other key stakeholders (e.g., customers, suppliers, the community, etc.) in concrete, adequately articulated ways. That allows you to take the words in the mission statement and devise goals and measures that you can use for incentives.

Mission-Driven Measures

Let’s consider an example of how this would work by using Southwest Airlines’ mission and vision, which together largely cover the three criteria for companies with mission-driven agility. “The mission of Southwest Airlines is dedication to the highest quality of Customer Service delivered with a sense of warmth, friendliness, individual pride, and Company Spirit.” The vision is “to become the world’s most loved, most flown, and most profitable airline.” The mission and vision provide enough specificity to formulate back-end outcome-based goals that tie to long-term incentives.

We don’t know the inside story of Southwest’s performance measures. But for the sake of illustration, we can paint a picture of the kinds of measurable outcomes and goals that would naturally follow to support the mission rather than the strategy. As for unique, spirited customer service aimed at customers, the firm could use a number of common outcome measures, including Net Promoter Score (for customer loyalty), Customer Effort Score (for ease of customer interaction or resolution), Customer Satisfaction Score (for degree to which products or services meet or exceed customer expectations), 5 Star Reviews (for overall customer rating from 1 to 5 stars), or Churn Rate (for customer retention).

As for outcome measures of the most loved, flown, and profitable, you could measure total number of passengers or passenger miles flown, commercial aviation brand strength relative to the industry and over time, popularity among customers relative to the industry and over time, and profitability and returns relative to competitors and over time.

Note how each would measure progress against the mission but not limit the evolution of strategy driven by bottom-up innovations by agile teams. In that employees are the stakeholder group that ultimately delivers on the mission, the company could also measure outcomes that demonstrated employee satisfaction and productivity. Such measures might include one or more of scores for employee engagement, attitudes, satisfaction, or turnover rates. To keep pay design streamlined, some of these measures would be tracked only, not also tied to compensation.

Note, too, that all of these outcome measures show the direction of improvement in keeping with the mission. They are specific enough to guide short- and intermediate-term goals related to strategy, which drive—but don’t limit—innovation-driven progress on the mission. These shorter-term measures might, of course, change yearly with the strategy but would include milestone measures (for example, on-time flights as a percentage of all flights) and process-improvement goals (measures of maintenance procedures or staff scheduling performance).

The Southwest example illustrates the bookend approach to mission-driven agile companies. The mission details up front the benefits and beneficiaries of the company’s work. The detail allows an articulation of performance measures for long-term incentives. Those measures are broad enough that they don’t perversely motivate executives to fulfill an obsolete strategy. The strategy of the moment gets emphasis in annual incentives.

As for the form of long-term incentives, the compensation committee could logically offer performance-based equity, where earn-out and compensatory value links directly to the value created via the mission. In the place of almost solely financial goals in today’s long-term incentives, the new pay plan would include a mix of financial and nonfinancial outcomes-based measures that both support the executives’ commitment to strategic agility and demonstrate success in fulfilling the company’s mission.

To further motivate executives to focus on the long term, compensation committees could also require executives to hold a significant amount of stock for the long term. They might at the same time set goals to stress yearly continuous improvement, as well as superior results compared to competitors, rather than absolute goals based on a negotiated end point. As yet a further way to motivate executives, the committee could structure payouts to cover improvement cycles from start to finish, in place of today’s overlapping, three-year measurement periods that reset performance targets each year.

Beyond Convention

As the Southwest illustration shows, in the era of strategic agility, companies have the option to swim against the tide of convention. They can embrace strategic agility as a new approach to strategic planning and execution, and in turn, design new long-term incentives that flow from the long-term enduring guidance of the mission.

The company’s mission, elaborated by its vision, then becomes the only “true north.” When an industry is in flux, long-term incentives should reward the next wave of mission-driven strategic agility, not today’s soon-to-be-obsolete three-year strategy. Boards can then be sure their companies are not driven by—and their executives are not given long-term incentives for—executing an extension of the past, but instead are encouraged to leap to the future.

Barry Sullivan and Seymour Burchman are managing directors at Semler Brossy Consulting Group.